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On September
4, 2013, the internationally prominent economist Raghuram Govind Rajan took
charge as the 23rd governor of the Reserve Bank of India. He decided in June to depart at the end of his politically
tumultuous three-year term, and with the August 20 announcement of his
successor, deputy governor Urjit Patel, the book on Rajan is officially closing.

A former
International Monetary Fund chief economist and University of Chicago finance
professor, Rajan came in with a “rock star” image, a contrast to his
predecessor, Duvvuri Subbarao, whose performance was the worst ever by an RBI
governor, according to Arvind Panagariya, then professor of economics at
Columbia University and now vice chairman of the government think tank NITI
Aayog. Subbarao had kept the Indian economy relatively stable during the global
crisis period. By the time he entered into the second phase of his tenure, in
2012, the economy was marred by nearly 10% inflation, a depreciating currency
and low GDP growth.

Rajan
dazzled with degrees from IIT (Indian Institute of Technology), IIM (Indian
Institute of Management) and MIT (Massachusetts Institute of Technology) and a
reputation for speaking his mind, was widely credited with predicting the 2008
crisis, and key economic indicators seemed to respond immediately to his moves.

Anticipated
Criticism

When Rajan
addressed the media after assuming office, he said, “Some of the actions I take
will not be popular. The governorship of the central bank is not meant to win
one votes or Facebook ‘likes.’” He said he sought “to do the right thing, no
matter what the criticism, even while looking to learn from the criticism” —
words that turned out to be prophetic.

Over the
three years that ended September 4, 2016, Rajan did mostly the right things. He
brought inflation down, stabilized the rupee, and GDP was going in the right
direction. Yet he could not escape criticism.

There was
really no end to the tug of war between him and the government over interest
rate cuts. The government continually pushed for greater cuts, while Rajan
refused until inflation fell within the targeted range. But even when inflation
was within the targeted range, Rajan did not cut the rates as much as the
government would have liked, citing risks in the global economy, rising crude
oil prices and uncertain monsoons.

Rajan was
also quite vocal about issues that did not directly come under his purview.
That did not sit well with the government, which needed to tread carefully due
to Rajan’s positive image amongst industry, the media and general public.

Return to
Academia

Subramanian
Swamy, a Harvard University PhD in economics and member of the Upper House of
the Parliament of India, stepped up as the central banker’s vocal public
critic. He was allowed to rant against Rajan for a long time before Prime
Minister Narendra Modi made his unhappiness over the entire issue known,
subtly, in a television interview. By then, Rajan had already issued a
statement saying that he would not be seeking another term and would return to
Chicago’s Booth School of Business, from which he was on leave.

There was
outrage. There were letters of support for Rajan, speculations about who would
succeed him and how he or she would measure up to Rajan in stature,
independence and ability to complete policy and regulatory changes in progress.

Modi’s
choice of Urjit Patel was seen as a safe one. Patel has a doctorate in
economics from Yale University, along with degrees from the University of
Oxford and London School of Economics. He has done stints at the International
Monetary Fund, World Bank, Brookings Institution, Reliance Industries and
Boston Consulting Group, and has been associated with various central and state
government task forces and committees.

Patel is
known to be the architect of the current monetary policy framework of RBI,
which focuses on inflation targeting. He is quieter and lower-profile than
Rajan. The consensus is that continuity in policies will be maintained and that
the government did well in appointing an “insider” to succeed Rajan.

How and why prices can move when company founders and insiders pledge
shares as collateral

Pledging of shares as loan collateral by company founders, insiders and
majority shareholders is legal in a number of countries, including the U.S. and
the U.K., although disclosure norms vary from country to country. The U.S.,
U.K., Australia, and Hong Kong, among others, mandate disclosure of share
pledges. Pledging of shares by
founder-promoters is very popular in India, where disclosure became mandatory
from January 28, 2009.

Background

On January 7, 2009, Mr. B.
Ramalinga Raju, the founder-promoter of Satyam Computer Services, a company
listed on the Indian bourses as well as the New York Stock Exchange, disclosed
to the company’s board that he had raised Rs. 12.30 billion (then equivalent to
around $253 million) by pledging Satyam shares to various institutions and had
used the money for personal purposes. Satyam’s share price on
the Indian bourses dropped by 87% over the subsequent two trading days, and
they lost 94% of their value on
the NYSE on January 7.

In the aftermath of this
revelation, the Securities and Exchange Board of India (SEBI), the Indian
regulatory equivalent to the U.S. Securities and Exchange Commission (SEC),
appended Regulation 8A to the existing Substantial Acquisition of Shares and Takeovers
(SAST) Regulations of 1997. The new regulation mandated disclosure of share
pledges to the stock exchanges within seven days, which then had to make this
information public within a further seven days. This sequence of events led to
the popular perception that share pledges on average conveyed negative
information about firm value and prospects.

The What and How of Pledging

In the Indian context, share
pledges are collateral for secured fixed-maturity personal loans, with the
company's shares acting as collateral. The typical tenor of the loan is between
three months and two years. The interest rate is two to three percentage points
higher than that of corporate loans.

At the lender's discretion,
the loan may be rolled over. The borrower could be the company's founder, a
member of the board, an executive, majority shareholder, employee, or even a
small shareholder. However, disclosure of share pledges is mandatory only for
certain shareholders, which vary by country. In the U.S., U.K., and Australia, mandatory
disclosure applies to all directors. In Hong Kong, it applies only to the
controlling shareholder. In India, it applies only to the promoters.

Under SEBI regulations, at the time of initial public offering (IPO),
companies are mandated to identify a promoter or promoter group, or even
another company as a promoter. While SEBI regulations do not formally define
who or what is a promoter, it is usually the founder of the company. Promoters
are not required to have a majority stake in the company.

Bank Limits

As per banking regulations in India, commercial banks may not provide
loans against share pledges. Only non-banking financial companies (NBFCs) are
allowed to do so. While NBFCs
perform functions similar to those of banks, they cannot accept demand
deposits. They are not part of the payment and settlement system and hence
cannot issue checks drawn on themselves. Their deposits are not covered by
India's Deposit Insurance and Credit Guarantee Corporation Act.

The annual value of the share pledge market in India is estimated to be
around Rs. 2 trillion (about $30 billion) as of December 31, 2015, as per the
data compiled by Prime Database. The NBFCs usually get shares worth two times
the borrowed amount. Borrowers receive a margin call if the value of shares
drops to between 1.25 to 1.50 times the borrowed amount. The exact multiple
depends on the NBFC’s “comfort level” with the promoter.

It must be noted that in addition to the collateral of pledged shares,
the loan to the promoter may also be secured by personal guarantees, pledge of
other assets, etc. However, the authors’ discussions with NBFCs reveal that
they consider the pledged shares as the primary collateral for the loan,
especially since enforcing recourse through personal guarantees and other
assets almost surely involves going through the notoriously tardy and
overburdened legal process in India.

If the borrower does not respond to the margin call, and the share price
continues to decrease, the lender invokes the pledge and becomes the owner of
the shares and may recover the borrowed amount by selling the shares on the
exchange. If the borrower repays the entire principal and all accrued interest
by the loan's maturity date, the pledge is said to be revoked and the borrower
continues to own the shares.

Reasons for Pledging

The commonly cited reasons for pledging the shares by promoters are:

1.To increase personal stake in the company
through open market purchases.

2.To fund other group companies.

3.To meet the company’s short-term working
capital requirements.

4.To provide a long-term loan to the company.

5.To finance takeovers by group companies.

6.To cover personal expenses.

Positive or Negative Signaling

The end use of capital borrowed through share pledges became a
hot-button issue in the aftermath of the Satyam transaction. Though
practitioners and the popular press note that markets react negatively to share
pledge announcements, there is no systematic empirical evidence on the issue.
Markets could react either positively or negatively to share pledge
announcements.

If the promoter uses the funds to increase her stake in the company, an
outside shareholder may view this as a sign of the promoter’s confidence in the
future performance of the company, resulting in a positive impact on share
prices. A lender’s acceptance of the shares as loan collateral also sends a positive
signal to the market.

Another positive interpretation of a share pledge is that the company
has a positive net present value (NPV) project on hand, and hence the promoter
is willing to pledge shares to raise capital for the project.

In contrast to the above, there are a number of reasons for interpreting
a share pledge as a negative signal about the company’s current and future
prospects. In falling markets, the lender may be forced to invoke the pledge.
To recover the loan, the lender may turn around and sell the shares in the
market, putting additional downward pressure on stock prices. This could result
in huge losses to existing shareholders. If the market believes that this is the
likely outcome of a share pledge, markets will react negatively at the time of
share pledges.

Further, when the pledge is invoked, the promoters stand to lose control
of the company. This may be detrimental to the future prospects of the company,
especially if the promoter has some specialized skill or knowledge that is not
easily transferable or replicated.

Another interpretation could be that the company is in a dire cash flow
situation, and the promoter is bailing it out by borrowing at a higher interest
rate. The market may also interpret the share pledge as the promoter having
private information of a large negative signal. The promoter may prefer not to
sell her shares for liquidity and price impact reasons. Share pledges are an
alternate way of encashing her shareholdings before the bad private information
becomes public. In this case, the promoter could be perceived to be pledging
shares with no intention of repaying the loan.

Empirical Evidence

Since a share pledge can be interpreted in either way, the authors
analyzed a sample of 2,567 share pledge announcements in India, with data
collected from the National Stock Exchange of India (NSE) website. All these
pledges were after the SEBI disclosure rule of January 2009.

Standard event study methodology with a market model, using the S&P
CNX 500 Index as a proxy for the market, is used, along with an estimation
window of 220 trading days. We find that the average cumulative abnormal return
(CAR) on the date of a share pledge ranges between -0.53% [-1 to +1; 3 day
window] and -2.35% [-10 to +10; 21 day window], depending on the width of the
event window around the day the promoter pledges shares.

There is a much smaller reaction, between -0.05% and -0.58%, around the
day the company reports the share pledge to the exchange. Our conversations
with practitioners revealed that there is no restriction on the promoters, the
NBFC or any other market participant regarding communication of information about
the pledge between the date of pledge and the date of announcement of the
pledge by the stock exchange. Our results support this as the market reaction
is much larger around the share pledge date than on the announcement date. There
is most likely immediate leakage of information, and hence the market reaction
is larger around the pledge date rather than announcement date.

Interestingly, though the average CAR is negative, only 56% of all CARs
in our sample are negative. Contrary to the popular view, only a small majority
of share pledges convey bad news.

Revoking Pledges

The authors also examine market reaction around the revoking of share
pledges, that is, when promoters repay the loan and recover their pledged shares
from the lender. Regulation 8A of SAST Regulations 1997 mandates the disclosure
of the revoking of share pledges, much like with share pledges.

Regardless of the reason for a share pledge, revoking it would
demonstrate the promoter’s ability to repay the loan. If the reason for the pledge
was personal use, its revoking would signal to the market that the promoter had
borrowed money for legitimate personal reasons and has promptly repaid the
loan. If the reason was a short- or long-term loan to the company or a working capital
requirement, revoking of the pledge would signal the company’s ability to repay
promptly, and hence its good financial health.

Thus, revoking of a pledge should send a positive signal about the
promoter and the company to the market. From study of a sample of 2,171 pledge revocations
from the NSE website, it was found that markets do not react significantly on
the day the pledge is revoked. This is puzzling, given the expectation that the
market will react positively.

Conclusion

Pledging of shares acts as an important
signal to the market. Pledging may be an easy way to raise money quickly, especially
when capital market conditions are tight. More and more promoters in India are
resorting to share pledges in recent years. The reason behind the pledging of shares
must be investigated before investing in companies where the promoters have
pledged a significant percentage of their holdings.